The Counter-Intuitive Investor

How Important Is Portfolio Diversification and Correlation?

Anyone who followed Jim Cramer on his popular “Mad Money” nightly television program is aware of his segment, “Am I Diversified?” that he runs during the program. “Cramer”, as he likes to be called, considers diversification vitally important to an individual investor’s success, and rightly so. In my opinion, this is the most important part, of an excellent educational program explaining stocks and the stock market.

What is diversification and is it really effective? A simple way to think about it follows the axiom of “not putting all your eggs in one basket”. If all of an investor’s money is in one stock and the stock goes ‘south’, then so will his total portfolio. If, on the other hand, a sufficient number of other unrelated stocks make up the rest of the portfolio, then these other stocks should moderate the negative effect of the poorly performing one. At least that’s the way it’s supposed to work. Unfortunately, during a stock market crash or severe correction, most stocks in a portfolio will often go down at the same time. But, if the stock market is at least treading water in a trend-less market, or experiencing a bull market, then adequate diversification should work well.

Many investors forget this lesson and instead tend to follow the questionable advice of John D. Rockefeller, who is alleged to have said, “Put all your eggs in one basket, but watch the basket”. That obviously worked well for him and his Standard Oil Corporation, one reason being the giant trusts (usually monopolies) that existed in the late nineteenth and early twentieth centuries, but this method is not likely to work out well today, unless the investor is simply lucky.

The most common mistake made with diversification is not in choosing an adequate number of different stocks on the portfolio, but in choosing those stocks that are least correlated and yet still fulfill the investor’s requirements for potential future price appreciation. Correlation refers to the tendency of two stocks to react either the same way to the same factors influencing change in the stock market (positive correlation), or to react differently to most of those same factors ( negative correlation). For example, let’s say oil prices decline 10 percent. This is bad for most oil companies (less profit), but good for most transportation companies (lower energy costs). Therefore, the energy sector and the transportation sector can be said to be negatively correlated, especially regarding energy prices. Two oil companies with similar businesses would be positively correlated.

In terms of reducing risk to the overall portfolio, the more negative correlation, the better. Adequate diversification can be defined as including adequate negative correlation. As a matter of fact, negative correlation can be thought of as a more specific form of diversification. This negative correlation requirement may not me met by simply choosing stocks in different industries, if those stocks tend to go up and down together anyway, which is actually more common than many investors think. An index fund which mimics the S&P500 (many different industries) would have more negative correlation than an index fund chosen to replicate one specific industry, such as energy, for the same reasons mentioned above. That’s why the investor should diversify by broad stock benchmarks, such as the S$P500, the Dow Industrials, and also by company size as well as by country (international), more so than by individual industries.

There is an easier way to achieve adequate diversification and negative correlation…and that is to bring in my favorite investment vehicle, the index fund. Readers of my previous blog posts may be getting tired of hearing how highly I value this investment vehicle (sorry, it’s necessary) over and above either individual stocks (even those recommended by Cramer on “Mad Money”) or managed mutual funds. If eight to ten stock index funds (as recommended in my Strategic a Stock Accumulation Strategy) are chosen in different benchmark indexes, as well as different countries, and stock sizes (within an index), then it would be very difficult to avoid a portfolio with both adequate diversification and negative correlation.

There would be hundreds of different stocks representing many different sources of capital in such a portfolio, instead of the common individual stock recommendation of only six to eight stocks for the entire portfolio! Also the cost to purchase such index funds could be zero, if they are purchased within a discount brokerage family of funds that maintains such a policy. Vanguard is one such discount brokerage firm with lower fees all the way around (personal disclosure: I’m a Vanguard client). There are certainly other discount brokerage firms offering this feature, and their numbers are growing, simply because of competition.

The cost to manage an index fund (i.e.,the expense ratio) is commonly rock-bottom as compared to managed mutual funds. Vanguard’s S&P 500 index fund expense ratio is 0.05%. Managed mutual funds, on the other hand, average over 1% per year. That’s at least twenty times higher! Plus, there is very little turnover in the typical index fund because stocks are not often bought or sold. They simply attempt to mirror an index benchmark, in which stocks likewise infrequently change. A managed fund, on the other hand, can easily have over 100% turnover per year! And guess who pays those transaction costs to buy and sell within the managed fund-You!

Most importantly, index funds out-return managed funds by a wide margin as time goes by. After ten years, the S&P 500 index fund outperforms at least 95% of the managed funds. A major reason for this astounding difference is the reduced index fund costs, which are very difficult for managed mutual funds to overcome.

If you are new to the online stock investment world, I would recommend setting up an account with a large well-known discount brokerage firm, such as Vanguard (best, in my opinion) or Fidelity. These discount brokerage firms are much less expansive than the typical full-service brokers and just as safe (well capitalized) in most cases. Set up an Asset Allocation, for example, 50% stock index funds! and 50% cash and bonds. Then have someone at the firm walk you through making a small limit order, not market order, index fund purchase. Once you become familiar with the process, you can graduate to larger buy and sell stock and bond (hopefully, you choose index funds) limit orders. You can learn to do this yourself, without paying those unnecessary higher brokerage fees.

Another option is to buy my book (How to Make a Fortune during Future Stock Market Crashes with Strategic Stock Accumulation) which explains a complete successful investment strategy, Strategic Stock Accumulation (which I back- tested myself , and compared with two other well- known stock investment strategies through six different time periods and stock market crashes, as well as bull markets). The SSA Strategy includes a step-by-step procedure for setting up an asset allocation consisting of stock, bonds and cash, all in index funds. The SSA Strategy then shows how to choose your Stock/Bond-Cash Ratio, based on your age. Next it describes how to decide when to buy and sell index funds after your particular asset allocation is set up. There is no guessing about whether the market is under or overvalued. Specific “buy” and “sell ” rules are very clear showing how to know exactly when and what stock market action to take.

Thus far, I’ve discussed the importance of diversification and negative correlation within the stocks (equities) of a portfolio. These two concepts are also important within the bond/cash portion of a portfolio. Bond index funds are also available for providing both diversification and negative correlation. One way of diversifying the bond portion of a portfolio is to buy bonds of different duration (time until the bond matures). Short-term, intermediate, and long-term bonds can be purchased to form a “ladder” of different time related bonds.

The difference between buying bond index funds in a ladder-type structure and individual bonds is that the short-term individual bond must be reinvested after it matures, in a longer-term individual bond. This is not necessary when diversifying by duration with bond index funds, as this function is performed within each fund, as the individual bonds mature. The main difference is that, within an index fund, the dollars resulting from the sale of maturing bonds are reinvested in new short-term bonds within the fund (not reinvested in longer-term bonds, as would be the case with an individual bond outside any fund).

As with stock index funds, bond funds can also be diversified by country. Another method of diversification is by credit rating. So-called high yield (or “junk” bonds) with lower credit ratings can be a good way to provide some additional negative correlation within the bond portion of the portfolio. Finally, of course, bonds can be diversified by duration ( time), as explained above.

Within the Strategic Stock Accumulation Strategy (SSA), short-term bonds only, make up the bond portion of the portfolio. In this case, the importance of quickly selling the short-term bonds with no significant capital loss (as such loss could easily be the case with longer-term bonds) trumps the value of diversification within the bond portion of the portfolio. These are the times the SSA strategy will dictate selling the bonds quickly in order to raise cash and buy stock “on sale” as the strategy describes. In most other strategies, however, it is important to always keep in mind, adequate diversification and correlation also within the bond portion of a portfolio. Achieving this requirement is made much easier when bond index funds are the vehicle for doing so.